Strong Comps Growth And Increase In China Stores Drive Improvement For Starbucks In Its Fourth Quarter

Starbucks (NASDAQ: SBUX) reported a strong end to its financial year, noting an 11% growth in revenues, 3% improvement in comparable sales, and a 13% increase in earnings in Q4, with all metrics exceeding consensus expectations. Although transactions were down 1% in the fourth quarter, pricing added four percentage points of growth, resulting in a comps improvement in all its geographic segments – Americas +4% (2.9% expected), China/Asia-Pacific +1% (0.1% expected), and EMEA +2% (1.0% expected). These positive results are encouraging, given a relatively weak first nine months, and show the steps undertaken by the company seem to be working. Starbucks is continuing to focus on accelerating its improvement in long-term growth markets of the U.S. and China, and focusing on the Global Coffee Alliance created with Nestle. For FY 2019, the company is expecting roughly 3% comps growth, 2,100 net new stores, driven by China/Asia Pacific, 5% to 7% revenue increase, moderate decline in operating margin, and 8% to 10% improvement in the EPS.

We have a $59 price estimate for Starbucks, which is in-line with the current market price. The charts have been made using our new, interactive platform. You can click here for our interactive dashboard on Starbucks’ Performance In Q4 & FY 2018 Versus Expectation to modify different drivers, and see their impact on the EPS and price estimate for Starbucks.

Key Factors That May Impact Future Performance

1. Growth in China: Although China has been the fastest growing market for Starbucks, the growth has been driven by the increase in store count. But this factor also caused cannibalization, which together with a sharp reduction in third-party orders resulted in a weak third quarter. As a response to this, the coffee giant has partnered with Alibaba to boost the company’s delivery services in the country. The company has also converted Mainland China into a wholly company-operated market, placing it in a strong position for long-term expansion. As a result of its efforts, Starbucks was rewarded with 1% improvement in comps in the quarter. The company has also expanded delivery to all its stores in Shanghai, Beijing, and 11 other cities in China, with an intention to expand to 2,000 stores by the end of FY 2019. Moreover, SBUX remains on track to add 600 net new stores per year and to achieve its goal of 6,000 stores in 230 cities across Mainland China by the end of fiscal 2022.

China continues to remain a long-term growth driver for the company, as its GDP, projected to exceed $15 trillion by 2021 from $11 trillion in 2014, is expected to fuel a massive increase in its middle class. Moreover, the per capita coffee consumption in China is about one-half of one cup per person per year compared to approximately 300 cups per person per year in the U.S. While consumption levels in China may never be able to match those in the U.S., even attaining a small fraction of it will benefit the company immensely.

2. Innovation in Food and Beverage: As consumer trends evolve, SBUX intends to stay ahead of the market with new and innovative products. Mercato fresh food menu was launched in Seattle and Chicago last year, and continues to perform well. Keeping this in mind, the company has deployed Mercato in nearly 1,800 stores across six markets. The company sees substantial accretive growth from Draft, Refreshers, Tea, and Cold Brew platforms, and noted that consumer demand for cold beverages has grown from 37% of sales five years ago to over 50% of sales today. There’s also strong demand for customization, including Blonde Espresso as an alternative to its bolder signature roasts, and the inclusion of plant-based milk and cold foam for its cold coffee and tea beverages.

3. Margin Contraction: Given the poor performance in the first quarter, Starbucks is removing over 200 SKUs from its U.S. retail stores, representing over 30% of total lobbied items. While this simplification effort increases the focus of the company and reduces operational complexity in its stores, it has pressured the margins given the high write-offs associated with these products. Moreover, the consolidation of the East China business also had a negative impact on the operating margins. Another factor that pressured the margins is the digital investments the company is undertaking in the Americas. Given these factors, the consolidated non-GAAP operating margin fell 170 basis points in the year. Looking ahead, the operating margin will continue to be pressured this year as a result of the digital initiatives, the East China acquisition, and the formation of the Global Coffee Alliance.

4. Share Buybacks: Last November, SBUX committed to returning $15 billion to shareholders in the form of buybacks and dividends through fiscal 2020. The company has expanded that to $25 billion, with $9 billion already returned to shareholders in FY 2018.

5. Deal With Nestle: Starbucks and Nestle announced plans for a $7.2 billion license deal that would allow the latter to market, sell, and distribute the coffee giant’s brands in Consumer Packaged Goods (CPG) and Foodservice. This global coffee alliance, which brings together the world’s leading coffee brand and retailer, and the biggest food and beverage company globally, gives Nestle a stronger footing in its fight against JAB Holdings, the world’s second largest player in the coffee space. For Starbucks, on the other hand, this deal paves the way for expansion into markets where the company has no CPG presence. Starbucks will also be supplying the coffee to both the Nespresso and Dulce Gusto machine platforms, opening its access to the addressable, single-serve coffee market. While the deal will hamper revenue and EPS growth for Starbucks in the short term (expected to have a negative impact of one to two points in FY 2019), it should become accretive to the EPS in FY 2020, earlier than FY 2021 stated previously.

6. Focus On Drive-Thrus: SBUX intends to open a majority of its new U.S. restaurants in middle America and the south, with over 80% of stores built in the year being drive-thrus. The company states that their research has indicated significant opportunities for store expansion in higher growth, lower cost markets, particularly when considering rising wages and occupancy costs, and hence, this will be a key focus in FY 2019. In the U.S., the company is also focusing on its digital initiatives, since it now has 15.3 million active Starbucks Rewards members, up 15% y-o-y. Additionally, drive-thru, out-the-window, and Mobile Order and Pay combined grew to more than 50% of customer orders, up more than 10 percentage points in just two years.

7. Improving Customer Connection: Starbucks is working on improving its customer image, and in this regard, it set itself an ambitious target of cutting up to 50% of current in-store administrative tasks by the end of FY 2019, in a bid to unlock up to two to three hours daily for partners to focus on customer connections.

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